Beyond Regulation: Why Bitcoin’s Pressing Problem is Civil Law

Most startups and entrepreneurs in the bitcoin or blockchain space have confronted the reality that governments take money crimes seriously.

Dealing with regulators is critical to post-implementation success and survival. But what entrepreneurs may not yet understand is that their new ventures exist interdependently with legacy legal systems.

What happens when bitcoin and blockchain startups stop worrying about regulatory compliance and start intersecting with these existing “real-life” systems? Said differently, how will the constructs and systems created to handle civil litigation adapt to bitcoin and the blockchain?

“Civil litigation” generally includes all non-criminal legal dispute resolution matters. Although many controversies are determined outside of courts (through arbitration, as is common in credit card disputes), the majority of non-criminal disputes in the US are resolved by civil litigation.

The US legal system provides the mechanism for dispute resolution through the laws and the court system. US law honors both legislatively enacted law and judge-made precedent, ie prior opinions of courts.

Although most who track the industry are aware of regulatory laws affecting bitcoin and blockchain platforms, there are few legal opinions issued by judges related to bitcoin and blockchain technology.

A review on Westlaw, a well-known legal research provider, reveals only 34 published judicial opinions nationwide mention bitcoin. Of those opinions, six were criminal and four related to regulatory enforcement actions.

Only 12 relate to non-criminal matters, and most of those opinions are related to claims against mining companies for failing to deliver mining equipment, attempts to recover bitcoins lost in Mt Gox or they relate to the use of bitcoin to barter for or purchase other goods and services.

These opinions, so far, do not provide precedent sufficient to instruct potentially confused judges who may confront bitcoin for the first time.

Bankruptcy

Take the bankrupt individual debtor who owns bitcoins. Or, consider the blockchain startup owner who never makes it to market.

Although these debtors may have fallen on hard times, the US Bankruptcy Code allows for debtors to disclose their assets and obtain a “fresh start,” with the accompanying discharge of their debts.

But, what happens if the bankrupt party fails to disclose his bitcoin holdings? What if the examining Trustee never asks about bitcoin?

Even if the Trustee is unaware of bitcoin and fails to inquire about the debtor’s virtual currency assets, and even if there is no clear line item for virtual currency assets on the current form of bankruptcy schedules (virtual currency assets are property, according to the IRS), failure to disclose assets may result in the debtor losing his or her ability to obtain a discharge. As a result, that debtor could remain saddled with his or her debts.

Or, consider the blockchain startup that never makes it to market. That debtor entity is equally required to disclose its virtual currency assets.

Courts, confused by or unfamiliar with bitcoin and virtual currencies, may view them with suspicion. A court may consider a transfer made in bitcoin to be inherently fraudulent.

Courts already use certain circumstantial indicators, known as “badges of fraud” by the Uniform Fraudulent Transfer Act (UFTA), when attempting to determine whether certain transfers of value are fraudulent. Among the badges considered, the court may look at a bitcoin transaction and determine that the transfer was (a) concealed, or that that the transfer was (b) made to conceal or remove assets, both of which are identified badges of fraud under the UFTA.

Although it is a fact-dependent inquiry, Courts will be forced to wrestle with and determine their policy positions regarding the intrinsic pseudo-anonymity of bitcoin with potentially uneven initial results.

One court may determine that bitcoin transfers are inherently concealed, while another court may determine that the use of bitcoin by itself is not intentional concealment.

Although this remains an unanswered question, the more reasoned conclusion is that transfers of value using bitcoin or a virtual currency, in the absence of other factors, should not be considered to be evidence of concealment or an intent to remove assets.

Divorce

Another instance involves divorcing spouses.

The husband, only understanding that his wife bought a large amount of computer equipment to mine bitcoin, files a petition seeking a divorce and wants to understand (and divide) his wife’s mining and bitcoin assets.

At her deposition, the wife says she never obtained any bitcoin over her years of mining.

How can the husband find out how much bitcoin she acquired? How does the husband’s lawyer actually discover evidence of her bitcoin holdings, or evidence of her transactions?

The husband’s lawyer can use the court’s power to obtain information (referred to in civil litigation as “discovery”) that will allow him to determine if there are any virtual currency assets available. That lawyer may attempt to analyze the physical mining equipment, if it is still available, which will require a Court order and likely an expert.

The lawyer may serve written discovery to attempt to identify transactions on the blockchain, and may require an expert to analyze the transfers. He or she will likely depose the wife and rely upon her oath that she will testify truthfully, and inquire about her mining and bitcoin use.

However, without undertaking proper discovery to identify transaction IDs or public keys, the discovery process is entirely contingent on the wife’s desire and ability to testify truthfully and fully about her bitcoin dealings.

Can the husband attach to (ie obtain possession of) bitcoin held by his wife?

As a practical matter, upon a proper evidentiary showing, he is probably authorized to do so, but must be able to evidence where the wallet resides so the court is able to exercise jurisdiction over that wallet.

It is suggested that the wallet will likely be determined to reside in the location of the private key (which provides control over the assets held in the wallet), or in the case of a multi-sig wallet, private keys.

Education needed

Although the bitcoin and blockchain community has done an admirable job educating its regulators, the judiciary handles most routine business disputes, and to date, has yet to create a body of precedent, or a “common law” of bitcoin.

As bitcoin and blockchain technology looks beyond regulation, bitcoin users and blockchain innovators will inevitably find themselves in business lawsuits, divorces and bankruptcies and must be prepared to educate the judiciary about this new paradigm.

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